Gretchen Morgenson Collects a Scalp: Blackstone Ditches Private Equity “Termination Fees”

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There’s nothing like seeing the good guys score a goal. We have two this evening. One is a win by David Sirota, whose reporting on San Francisco’s plan to shift up to 15% of retiree funds into hedge funds appears to have led to a climbdown by the city. Sirota uncovered an unreported conflict of interest by the consultant recommending the change, who also operates a hedge fund of funds. Admittedly, CalPERS’ recent announcement that it was exiting hedge funds entirely also put pressure on the city to reverse course.

But Gretchen Morgenson collected an even bigger scalp in the form of Blackstone halting a practice that she highlighted in a May article: that of taking “termination fees” when portfolio companies are sold. However, as we discuss later, as positive as this move appears, this is almost certainly Blackstone throwing a big, visible bone to investors in the hope of deterring an SEC enforcement action.

Understand how this scam worked. Portfolio companies are made by their new private equity overlords to enter into various agreements that require them to pay fees to the private equity fund manager, aka the general partner.

Limited partners, as in the fund investors, over time wised up to how much was being taken out of companies the private equity funds by the general partners, and pushed back. The concession was to have the big fees that the investors knew about, which were the “transaction fees” and “monitoring fees” rebated against the annual management fee the investors were paying (note that since the amount rebated is limited by the amount of the annual fees, this isn’t an ideal solution, but we’ll skip over that).

However, the only fees the limited partners got rebated were ones that were specifically identified in the limited partnership agreements. We’ve pointed out, as has the SEC, how much these contracts fail to do a good job of protecting investor interests. One of the ways is that the do not require the private equity funds to disclose all the fees and expenses that they charge to portfolio companies.

Morgenson’s article focused on one of those sneaky non-disclosed, and therefore not shared fees, the so-called “termination fees”. In her story, “The Deal’s Done. But Not the Fees,” she explained the ruse: when a private equity portfolio company is sold, all of the future monitoring fees come due in a one-time, present value payment. This payment is not shared with investors and thus reduces the proceeds of the sale. The example she used was from a so-called club deal, a company called Biomet purchased Blackstone, Goldman, KKR, and TPG.

The chart below, from her story, gives a more general picture of how this scheme worked.

Screen shot 2014-05-25 at 1.17.45 AM

And remember, this was simply one type of non-disclosed fee that the New York Times reporter unearthed. The SEC’s Andrew Bowden strongly suggested that this may not be the only type of covert fee:

“In some instances, investors’ pockets are being picked,” Andrew J. Bowden, director of the S.E.C.’s office of compliance inspections and examinations, said in a recent interview. “These investors may be sophisticated and they may be capable of protecting themselves, but much of what we’re uncovering is undetectable by even the most sophisticated investor….On money moving from the portfolio company to the adviser,” he said, “there is not a level of transparency sufficient to allow investors to protect themselves, no matter how smart they are.”

Morgenson discussed another type of abuse that the Wall Street Journal had previously highlighted, that of private equity firms hiring contractors or affiliates to provide services that investors thought were part of the general partner’s overhead. Instead, these costs are billed as expenses to the portfolio companies. The Wall Street Journal did in-depth reporting on an extreme example, that of KKR’s captive consulting firm Capstone; Morgenson exposed other examples of the same practice, along with other forms of grifting, such as having the funds pay for family members to travel on private jets (remarkably, that provision is usually disclosed in the limited partnership agreements and investors fail to protest, a proof of how badly captured they are). The Financial Times followed with a story on fee on the unseemly magnitude of fees that firms like KKR are taking out of portfolio companies.

We’ve been told that investors are disturbed about the idea that they may be having fees stripped out of their investments in ways that are hidden to them. But most have convinced themselves that they have to invest in private equity funds, so unless they work in concert, or an an industry leader like CalPERS takes action, the odds that any one firm will rock the boat is low.

Thus aside from the media, the most likely source of pressure is the SEC. The agency’s initial salvo, calling out bad practices in remarkably specific detail, is almost unheard of among regulators. However, the agency appears to be quietly retreating, in the apparent naive hope that the private equity firms will clean up their behavior. The reality is that the most likely outcome is that they will make token concessions and paper up future deals more artfully.

Thus as encouraging as the Blackstone climbdown on termination fees appears to be, it’s almost certainly a strategic sacrifice in the expectation that a few earnest-looking moves will forestall SEC enforcement actions. Key details from the Wall Street Journal story:

The world’s largest buyout firm will curb a controversial fee practice that is under scrutiny from regulators and investors…

The shift could save Blackstone fund investors tens of millions of dollars, and cost Blackstone the same amount in the process, and represents a significant U-turn in a long-standing industry practice. Blackstone’s move follows criticism this year from a senior Securities and Exchange Commission official about the practice and could put pressure on other private-equity firms to follow suit, industry executives said.

At issue are consulting payments typically known as “monitoring fees.” Blackstone and other large private-equity firms often enter into contracts with companies they buy to earn these fees for a set number of years, often a decade or longer.

If a company is sold or taken public before then, the contract often dictates that the company “accelerate” the remaining fees, by paying a lump sum for years of future consulting work the private-equity firm won’t have performed.

Blackstone’s accelerated-fee practice was “not helpful” to the firm’s relationship with fund investors, according to a person familiar with the matter. The firm made changes partly because of the bad perception it could engender, this person said.

Blackstone no longer will collect these additional fees after divesting companies it buys in the future, this person said. When Blackstone gets such fees from companies already in its portfolio, the buyout firm will distribute them to investors or cut other fees by a commensurate amount.

While this is a positive step, let us not kid ourselves. The Blackstone protest that they wanted to appease investors is unlikely to be the operative truth. The giant buyout firm, along with other private equity firms who charge termination fees, are vulnerable to SEC enforcement actions on this very practice. The SEC could not only assess fines, but could potentially order the repayment of past termination fees if the SEC felt they were an impermissible or abusive practice. Thus Blackstone is hoping to give the SEC a media win while retaining its past questionably-gotten gains.

So continue to beware of Greeks giving gifts. Private equity firms never give free concessions. This climbdown strongly suggests that Blackstone saw the odd of an enforcement action as high and wanted to give the SEC an easy way out.

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  1. Dan

    Please don’t use expressions like “catching a scalp,” etc.; I know you’re progressive and make a real contribution to our shared efforts, but this is an expression with longstanding, racist roots, and should be dropped. Thank you for your consideration.

    1. Yves Smith Post author

      I am at a loss to understand your complaint.

      The American Indian tribes that engaged in scalping were fierce warriors, feared by settlers/occupiers. So you are saying American Indians should be ashamed of their heritage? “Taking a scalp” is high praise, an expression with positive associations.

      By contrast, people routinely talk about being chained to their desks, yet I’ve never encountered anyone who objected to that turn of phrase, when it clearly invokes slavery.

  2. trinity river

    We are the elite:
    In the early days of private equity & before it became a normal operating procedure in the U.S., PE gave the story line that they were going in and rescuing companies from bad management. This was a lie then. I watched from the outside in seven cases and from the inside in one during the 80s.
    In the cases I observed, they went in and stripped out overfunded pension funds*. Dropped the defined benefit plans, instituted 401Ks. They dropped large research departments (mfg) filled with great engineers and pregnant research. They laid off senior employees to reduce wages and generally shrunk the labor force. They broke the company into salable parts and sold them for more than they bought the company for. All in the name of making the companies more efficient. I looked at it as highway robbery and thought it should have been illegal. Where am I getting it wrong? Now I’m learning they charged the company fees for doing it And they charge investors hidden fees to boot.
    Private equity did this first by borrowing large sums of money, buying the company, most often in a hostile buy-out telling current shareholders that they were helping them. Did they? Just who got the loot? After the transformation was done, they transferred the debt to the acquired company.
    There is always a good story line up front. We have been hoodwinked.
    Yves, do I have any of this wrong.

    *Yes, there were overfunded pension funds since companies went on the assumption that they needed to put in sufficient funds in good times to be ready for bad times.

    1. Left in Wisconsin

      Seems right to me. Only thing different in my experience – also mfg – is that lots of businesses were acquired really cheap not with intent to sell later for more but just to run down and squeeze out every last penny before shuttering. Bank loans repaid out of operating cash flow but no intent to improve and sell on.

      1. susan the other

        And that agenda makes “termination fees” almost look like a smokescreen to hide the fact that that was the plan all along. When a company is raped so blatantly, you gotta pretend you didn’t really do it.

  3. TheCatSaid

    More transparency is needed relating to ALL fees and other commitments PE firms require–both to the portfolio companies (e.g. obligation to use a connected company for auditing or other services, whose charges and deliverables have not yet been discussed at the time an agreement is made) and to the LP investors. All parties should be aware of the income streams on all sides of the equation.

    Maybe simplified terms & conditions are needed, so that deals can be easily compared.

    How about a CFPB for PE and similar investment vehicles? It’s clear the SEC is not functioning in this capacity.

    We should not underestimate the harm that is done to both investors (including pension funds from many of us), but also to the portfolio companies. If we’re expecting groaf to come from new technologies, innovation, etc., and at the same time we’re promoting PE funding of these early stage companies, we’re killing off any potential this kind of financial system might have to contribute any benefit to society at large.

  4. Paul Walker

    …and wanted to give the SEC an easy way out.

    The SEC is a PE industry neighborhood share toy. No way the SEC will ever spurn its private equity partners desires while being driven along on their joy-joy rides around the neighborhood .. Or back-off-yo-back-on an eye wash enforcement action during their PE designated target heart rate achieving rounds ’round the ‘hood without proper direction and encouragement. Especially when delivered to a preselected-scheduled destination.

  5. Larry

    It must just be too easy to make an endowment grow. Otherwise how could serious portfolio managers justify losing untold millions to fees?

    1. Lune

      Agency effect. If the pension fund manager is wine’d and dine’d with a lavish expense account by a PE firm, he will park a few million (or billion) with them in exchange. Just like PE firms, while being the nominal owners of their portfolio companies, have no problem bankrupting previously well-running companies since all that matters to them is extracting enough fees and “special dividends” to make their money back, pension fund managers really have no incentive to do anything more than not stray too far from their “peer” funds. After all, their retirement security isn’t dependent on the pension fund (or endowment) they’re managing.

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